Economics
Equilibrium in Foreign Exchange Market
Equilibrium in the foreign exchange market refers to the point at which the supply of and demand for a currency are balanced, resulting in a stable exchange rate. At this equilibrium, the quantity of a currency supplied equals the quantity demanded, preventing any immediate pressure for the exchange rate to change. This balance is influenced by various factors, including interest rates, inflation, and market speculation.
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12 Key excerpts on "Equilibrium in Foreign Exchange Market"
eBook - PDFInternational Trade and Agriculture
Theories and Practices
- Won W. Koo, P. Lynn Kennedy(Authors)
- 2008(Publication Date)
- Wiley-Blackwell(Publisher)
The amount of foreign exchange demanded varies inversely with its price; the amount demanded at a high rate is less than the amount demanded at a low rate, provided that other economic factors (prices, interest rates, and real income) remain the same. Unlike the amount demanded, the quantity of foreign exchange supplied to the market varies directly with the rate of exchange. The market-clearing exchange rate is determined by the intersection of the demand and supply schedules. Once an equilibrium is achieved, the exchange rate will remain stable until a shift occurs in either the demand or supply schedule. The discussion of variables influencing the supply and demand for money focuses on three general factors: (1) the desire to import goods and services; (2) the desire to travel abroad; and (3) the desire to invest abroad. In addition to these three factors, there are other, more specific, factors that affect the exchange rate. These include real income, interest rates, and prices. The current account balance is the difference between exports and imports. The Marshall-Lerner condition and the J-curve effect are used to illustrate the interaction between the current account balance and the exchange rate. The currency exchange market is the market in which international currency trades take place. It involves interactions between currency buyers and sellers. The price of curren- cies, or the currency exchange rate, is influenced by the underlying factors of currency supply and demand. When a currency depreciates, it loses value relative to other currencies. Given a depreci- ation of a currency, foreigners find exports cheaper as residents find imports more expens- ive. Conversely, when a currency appreciates, it gains value relative to other currencies. Given an appreciation of a currency, foreigners find exports more expensive as residents find imports cheaper. There are a variety of participants in the currency exchange market.
eBook - PDFExchange Rate Regimes
Fixed, Flexible or Something in Between?
- I. Moosa(Author)
- 2006(Publication Date)
- Palgrave Macmillan(Publisher)
The second problem is that the equilibrium values of the exchange rate are ranked differently by the two countries involved in the bilateral exchange rates. For example, one country may prefer E 1 while the other prefers E 3 . A situation like this could lead to conflict in the economic policies of the two countries. The third problem is that speculation as well as balance of payments disturbances may cause sharp fluctuations in the exchange rate, which lead to an unnecessary and wasteful reallocation of resources. For E 3 E 2 E 1 Q E S D Figure 2.11 Multiple equilibria in the foreign exchange market The Role of the Exchange Rate in the Economy 43 example, if the exchange rate rises slightly above E 1 , speculators will start buying the foreign currency, thinking that it will rise further. The exchange rate will rise beyond the unstable level E 2 , all the way to the stable level E 3 . When it reaches E 3 , speculators sell the foreign currency, causing the exchange rate to fall all the way to E 1 . The effect of a balance of payments disturbance is illustrated in Figure 2.12. A fall in the demand for foreign exchange is represented by a shift in the demand curve, and the equilibrium exchange rate falls from E 1 to E 2 . This big drop is caused by the backward-bending nature of the supply curve. Changes in the exchange rate would be less dramatic under a normal upward-sloping supply curve. The effect of the exchange rate on the current account of the balance of payments emanates from the effect of changes in the exchange rate on prices and, therefore, the demand for domestic and foreign goods (exports and imports). When the exchange rate rises (the domestic currency depreciates), prices of exports in foreign currency terms fall while prices of imports in domestic currency terms rise.
eBook - PDF- Dominick Salvatore(Author)
- 2014(Publication Date)
- Wiley(Publisher)
276 Part Four The Balance of Payments, Foreign Exchange Markets, and Exchange Rates 0 50 100 0.50 1.00 1.50 2.00 150 200 250 300 350 E' C G B A F H R = $/ S' D Million /day FIGURE 11.1. The Exchange Rate with Flexible Exchange Rates. The vertical axis measures the dollar price of the euro (R = $/¤), and the horizontal axis measures the quantity of euros. With flexible exchange rates, the equilibrium exchange rate is R = 1, at which the quantity demanded and the quantity supplied are equal at ¤200 million per day. This is given by the intersection at point E of the U.S. demand and supply curves for euros. At a higher exchange rate, a surplus of euros would result that would tend to lower the exchange rate toward the equilibrium rate. At an exchange rate lower than R = 1, a shortage of euros would result that would drive the exchange rate up toward the equilibrium level. If the U.S. demand curve for euros shifted up (e.g., as a result of increased U.S. tastes for EMU goods) and intersected the U.S. supply curve for euros at point G (see Figure 11.1), the equilibrium exchange rate would be R = 1.50, and the equilibrium quantity of euros would be ¤300 million per day. The Depreciation An increase in the domestic currency price of the foreign currency. dollar is then said to have depreciated, since it now requires $1.50 (instead of the previous $1) to purchase one euro. Depreciation thus refers to an increase in the domestic price of the foreign currency. On the other hand, if the U.S. demand curve for euros shifted down so as to intersect the U.S. supply curve for euros at point H (see Figure 11.1), the equilibrium exchange rate would fall to R = 0.5 and the dollar would be said to have appreciated (because fewer dollars are now required to purchase one euro). Appreciation thus refers to a decline in the domestic price of the foreign currency.
No longer available |Learn more- C. Fred Bergsten, John Williamson, C. Fred Bergsten, John Williamson(Authors)
- 2003(Publication Date)
35 2 The Dollar’s Equilibrium Exchange Rate: A Market View MICHAEL R. ROSENBERG In theory, a currency’s value should gravitate over time toward its real long-run equilibrium value. If we were able to estimate this value, invest-ors would be able to identify the likely path that an exchange rate will take on a long-term basis and position their portfolios accordingly. Unfor-tunately, there is no uniform agreement among economists either on what exchange rate level represents a currency’s true long-run equilibrium value or on the method that should be used to estimate its value. For instance, the method with the widest following among economists and strategists—the purchasing power parity (PPP) approach, which equates a currency’s fair value with the trend in relative price levels—is also widely recognized to have serious limitations because other fundamental forces have often played an important role in driving the long-term path of exchange rates. The purpose of this paper is to describe how equilibrium exchange rate modeling can be useful for foreign exchange market participants. One of my principal goals is to demonstrate that equilibrium exchange rate modeling is not purely an arcane academic exercise. I begin by discussing the fundamental equilibrium exchange rate framework pioneered by John Williamson. I then survey several modeling attempts that use the FEER framework as well as others undertaken in recent years to estimate where the dollar’s equilibrium value versus the euro lies. Michael R. Rosenberg is managing director and head of global foreign exchange research at Deutsche Bank. Prior to joining Deutsche Bank in May 1999, he was managing director and head of international fixed income research at Merrill Lynch for 15 years. 36 DOLLAR OVERVALUATION AND THE WORLD ECONOMY Most model-based estimates suggest that the dollar is significantly over-valued versus the euro. I suggest that those estimates might be understat-ing the dollar’s true equilibrium value.
eBook - PDF- Dominick Salvatore(Author)
- 2020(Publication Date)
- Wiley(Publisher)
On the other hand, if investors sell foreign bonds either because of a reduction in the interest rate abroad relative to the domestic interest rate or because of a reduction in their wealth, the supply of the foreign currency increases and this causes a decrease in the exchange rate (i.e., appreciation of the domestic currency). Thus, we see that the exchange rate is determined in the process of reaching equilibrium in each financial market. A more formal presentation of this portfolio balance approach and exchange rate determination is presented in Section A15.2 of the appendix. 15.4B Extended Portfolio Balance Model In this section, we extend the simple portfolio balance model just presented by specifying a more complete set of variables that determines the demand for money ( M ), the demand for the domestic bond ( D ), and the demand for the foreign bond ( F ) of residents of the home country. From our simple portfolio balance model presented previously, we already know that M , D , and F depend on the domestic and the foreign interest rates ( i and i * ). The additional variables on which M , D , and F depend that are now introduced are the expected change in the spot rate (in the form of the expected appreciation of the foreign currency or EA ), the risk premium ( RP ) required to compensate domestic residents for the additional risk involved in holding the foreign bond, the level of real income or output ( Y ), the domes-tic price level ( P ), and the wealth ( W ) of the nation’s residents. We know from the uncovered interest parity condition (Equation (15-8)) discussed in Section 15.3C in connection with the monetary approach that i i EA * (15-8) That is, the positive interest differential in favor of the home country (the United States) over the foreign country (the EMU) is equal to the expected appreciation (expressed on an annual percentage basis) of the foreign currency (€) in relation to the home-country currency ($).
eBook - PDF- Dominick Salvatore(Author)
- 2019(Publication Date)
- Wiley(Publisher)
Thus, except for a currency-reserve country, such as the United States, the nation has no control over its money supply in the long run under fixed exchange rates but retains control under flexible exchange rates. An increase in the expected rate of inflation in a nation will immediately result in an equal percentage depreciation of the nation’s cur- rency. The monetary approach also assumes that the interest differential in favor of the home nation equals the expected percentage appreciation of the foreign country’s currency (uncovered interest arbitrage). 4. In the portfolio balance model, individuals and firms hold their financial wealth in some combination of domestic money, a domestic bond, and a foreign bond denominated in the foreign currency. The incentive to hold bonds (domestic and foreign) results from the yield or interest that they pro- vide. But they also carry the risk of default and variability of their market value over time. In addition, foreign bonds carry currency and country risks. Holding domestic money, on the other hand, is riskless but provides no yield or interest. The demand for money balances (M), the domestic bond (D), and the foreign bond (F) are functions of or depend on the interest rate at home and abroad (i and i * ), the expected appreciation of the foreign currency (EA), the risk premium on holding the foreign bond (RP), as well as real GDP (Y), prices (P), and wealth (W) in the nation. Setting M, D, and F equal to their respective supplies, we get the equilibrium quantity of money balances, domestic bonds, and foreign bonds, as well as the equilibrium rates of interest in the home and in the for- eign nations, and the exchange rate between their currencies. Any change in the value of any of the variables of the model will affect every other variable of the model. The exchange rate is determined in the process of reaching equilibrium in each financial market simultaneously.
- Michael Brandl(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
19 Foreign Exchange Markets 19-1 Foreign Exchange Market Basics 406 19-2 Foreign Exchange Supply and Demand 410 19-3 Foreign Exchange Equilibrium 415 19-4 Foreign Exchange Regimes 422 19-5 Conclusion 425 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Foreign Exchange Market Basics You have probably heard it hundreds of times: We live in a globalized world. It’s passé, but it is true. As the 2008 financial crisis demonstrates, our global economy is much more intertwined than it was a generation ago. This is not your parents’ global economy. As economies around the globe become more intertwined, the need to exchange currencies naturally grows. For example, suppose Hans in Stuttgart, Germany, wants to buy an American-made Dell computer. To buy the computer, Hans has to exchange his euros for US dollars. The same holds true for Stan in Milwaukee, Wisconsin, who wants to buy a bond issued by the British mobile phone service provider Vodafone. Stan has exchanged his dollars for British pounds to buy the Vodafone bond. As goods markets and financial markets around the world become more intertwined, the need to buy and sell currencies grows. The Bank for International Settlements reported that the average daily turnover in the foreign exchange market was an eye-popping $5.1 trillion during April 2016. The volume, which is down from $5.3 trillion three years earlier, is still a staggeringly large number. The large role the American economy plays in global markets can be seen in the fact that the US dollar was on one side of the trade in 88% of all FX trades in 2016.
eBook - PDF- Dominick Salvatore(Author)
- 2012(Publication Date)
- Wiley(Publisher)
Chapter Eleven The Foreign Exchange Market and Exchange Rates 287 0 50 100 0.50 1.00 1.50 2.00 150 200 250 300 350 E' C G B A F H R = $/ S' D Million /day FIGURE 11.1. The Exchange Rate with Flexible Exchange Rates. The vertical axis measures the dollar price of the euro (R = $/¤), and the horizontal axis measures the quantity of euros. With flexible exchange rates, the equilibrium exchange rate is R = 1, at which the quantity demanded and the quantity supplied are equal at ¤200 million per day. This is given by the intersection at point E of the U.S. demand and supply curves for euros. At a higher exchange rate, a surplus of euros would result that would tend to lower the exchange rate toward the equilibrium rate. At an exchange rate lower than R = 1, a shortage of euros would result that would drive the exchange rate up toward the equilibrium level. If the U.S. demand curve for euros shifted up (e.g., as a result of increased U.S. tastes for EMU goods) and intersected the U.S. supply curve for euros at point G (see Figure 11.1), the equilibrium exchange rate would be R = 1.50, and the equilibrium quantity of euros would be ¤300 million per day. The Depreciation An increase in the domestic currency price of the foreign currency. dollar is then said to have depreciated, since it now requires $1.50 (instead of the previous $1) to purchase one euro. Depreciation thus refers to an increase in the domestic price of the foreign currency. On the other hand, if the U.S. demand curve for euros shifted down so as to intersect the U.S. supply curve for euros at point H (see Figure 11.1), the equilibrium exchange rate would fall to R = 0.5 and the dollar would be said to have appreciated (because fewer dollars are now required to purchase one euro). Appreciation thus refers to a decline in the domestic price of the foreign currency.
- Michael Brandl(Author)
- 2016(Publication Date)
- Cengage Learning EMEA(Publisher)
By doing so, we will learn why forecasting exchange rate movements in the future is a very dif-ficult task. SECTION REVIEW Q1) Explain why the demand curve in the foreign exchange market slopes downward. Who causes it to have this shape and how? Q2) Explain why the supply curve in the foreign exchange market slopes upward. Who causes it to have this shape and how? Q3) When a central bank seeks to offset the impact of its attempt to influence the exchange rate of its currency on the monetary base, this action is referred to as: a. sterilization. b. counter-setting policy. c. liberalization. d. decontamination. Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 391 CHAPTER 2 Sample Design About Money Foreign Exchange Equilibrium Bringing together these two sides of the foreign exchange market results in an equilibrium, or a market-clearing, price. As with any market equilibrium, if the market price is above the equilibrium price there is a surplus and thus downward pressure on the price. Conversely, if the market price is below the equilibrium price there is a shortage and upward pressure on the price. 19-3a Movement to New Equilibrium We are more interested in how changes in supply and/or demand in the foreign exchange market bring about changes in the equilibrium price. That is, we are more interested in why appreciations and depreciations occur. First, assume that the exchange rate is determined solely by market forces.
eBook - PDF- Robert E. Lucas Jr., Max Gillman, Robert E. Lucas, Jr., Robert E Lucas, Max Gillman(Authors)
- 2013(Publication Date)
- Harvard University Press(Publisher)
45 . 3 . Equilibrium in a Pure Currency Economy* This paper studies the determination of the equilibrium price level in a stationary economy in which all exchange involves the trade of fiat money for goods. The use of money in exchange is guaranteed by the imposition of a constraint, as suggested by Clower in (1967), which requires that pur-chases of goods must necessarily be paid for by currency held over from the preceding period. The models examined also resemble closely that studied by Friedman in the first part of (1959). Individual behavior re-sembles that captured in inventory-theoretic models of money demand, as studied by Baumol (1952) and Tobin (1956), so that another way to think of the paper is as an attempt to study the transactions demand for money in as simple as possible a general equilibrium setting. In the next section, an example with perfect certainty is analyzed, with a digression to motivate the cash-in-advance constraint. In this example, which is a special case of the much more general set-up treated by Grand-mont and Younes (1972, 1973), equilibrium velocity is determined in an entirely mechanical way by the assumed payments period. In Section II, individual uncertainty is introduced, giving rise to a precautionary motive for holding currency and a non-trivial problem of equilibrium determina-tion, in which velocity depends on the kinds of economic factors long thought to be important in reality. The analysis of this latter case is contin-ued in Sections III–V. Economic Inquiry 18, no. 2 (April 1980): 203–220. * University of Chicago. This paper was prepared for the Minneapolis Fed Conference on Models of Monetary Economies, December 7–8, 1978. I want to thank Milton Harris for his helpful criticism.
eBook - PDF- Jan Herin(Author)
- 2019(Publication Date)
- Routledge(Publisher)
Under flexible ex-change rates instantaneous portfolio equilibrium is obtained through changes in the valuation of assets-that is, through changes in the exchange rate. Exchange rate in the short run and in the long run 169 Whereas a desire to hold. a larger proportion of foreign assets results in an immediate adjustment of private portfolios and has no long-run consequences under fixed exchange rates, such a shift under flexible exchange rates will give rise to a gradual adjustment process and will have long-run consequences. The exchange rate will depreciate initially and the current account will move to a surplus. This surplus increases the actual stock of foreign assets. In general, the exchange rate in the new equilibrium position will not be the same as before the portfolio shift because the long-run stock of wealth will be different. (iii) The dynamic behavior of the exchange rate and of the balance of pay-ments depends critically on the nature of expectations formation. Traditional theory has neglected the relevant problem of instability under flexible ex-change rates, i.e. the problem of instability of relative asset prices, by focusing on balance of payments flows. The crude purchasing power parity theory of exchange rates has also bypassed the problem of possible instability by ignor-ing the fact that different monies, and assets denominated in different curren-cies, are substitutes. The requirement of no expected profits does not rule out dynamic instability. 1 In fact, in the case of perfect foresight the exchange rate is indeterminate-for any initial exchange rate, there is a path along which all markets clear and expectations are continuously fulfilled. Only one of these paths converges to the stationary state. Since hyperdeflation, or inflation seldom, if ever, develops by force of speculative behavior alone, there must be reasons why the deviant paths cannot be sustained.
eBook - PDF- John F. Bilson, Richard C. Marston, John F. Bilson, Richard C. Marston(Authors)
- 2007(Publication Date)
- University of Chicago Press(Publisher)
The model of exchange rate determination developed in this paper also incorporates a theory of the determination of the real exchange rate by means of a general equilibrium specification of the condition of balance of payments equilibrium. This specification is consistent with the standard two- country, two-commodity model of the real theory of international trade, with the dependent economy model in which the home country produces and consumes its own nontraded good as well as a traded good that is a perfect substitute for goods produced and consumed in the rest of the world, and with the usual “Keynesian” model in which the home country produces an output that is distinct from the output of the rest of the world. An important feature of this model of balance of payments equilibrium is that both the level and the expected rate of change of the real exchange rate affect the desired difference between domestic spending and domestic income and the current account balance. Under the assumption of rational expectations, it follows that (the logarithm of) the real exchange rate that is consistent with balance of payments equilibrium (but not necessarily with a zero cur- rent account balance) depends on the long-run equilibrium real exchange rate and on the divergence between the actual level of net foreign assets held by domestic residents and the long-run desired level of such asset hold- ings. The dependence of the real exchange rate on the level of net foreign assets is consistent with the relationship described in a number of recent models of the dynamic interaction between the current account and the exchange rate.
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